Drama Over Due Diligence

In June 2001, a major institutional investor purchased a full-service medical plaza in the Pacific Northwest. Prior to purchase, the investor retained an engineering group to complete due diligence on the facility to highlight any problems. The exercise revealed only minor problems, and the investor proceeded with the purchase.

Three months after the acquisition, the investor received notice from the local municipality that various fire code violations were in existence at the property, and that the violations would need to be corrected within 180 days. Violations centered on inadequate fire proofing and an incomplete fire-suppression system.

Correction of the violations cost the investor about $1.25 million and required the removal of tenants. Essentially, the facility was closed for four months. Upon completion of the required improvements, the investor had expended over $2 million in repairs, lost rent, consulting fees and fees associated with reinstatement of the building.

Furthermore, as a result of the structure of the leasehold agreement, tenants were allowed to forfeit their leases due to the disruption and timing of the work. The investor was left with a half-empty building and a $2.15 million payment.

How could this happen? The deficiencies were not noted prior to acquisition because of ineffective due diligence. Unfortunately, that scenario is not an isolated case. Each year in the U.S., ineffective due diligence costs unsuspecting investors tens of thousands of dollars and leads to countless lawsuits.

How to protect yourself

Any space user or investor who has purchased real estate has likely gone through due diligence — the process of investigating and evaluating the physical, environmental and financial health of the assets in a transaction.

Historically, purchasers of commercial real estate have commissioned engineering evaluations prior to acquisition. The purpose of that evaluation is to inform the buyer and financial backers about the property's condition, and determine what financial investment will be required to repair or improve the facility during the hold period. Many sellers also perform due diligence prior to disposition to fully understand the condition of their facility.

With prices of institutional-grade property escalating, it is hard to believe that some owners and investors still place only minimal importance on the quality of the due diligence process. Many see it as a process that can be completed in-house to save money, and where minimum standards can be followed.

In most industries, minimum standards are in place to ensure that each and every contractor or consultant performs work to those standards. However, what if those minimum standards were not adequate, but were often perceived to be adequate by buyers and sellers? Furthermore, what would happen if the inadequacy of these standards led to bad advice on a multi-million-dollar investment?

Unfortunately, this is the case when one considers the standards governing the field of pre-and post-acquisition due diligence. Physical due diligence — which includes evaluation of a facility's architecture, structure and physical plant — is covered by the ASTM International's “Standard Guide for Property Condition Assessments: Baseline Property Condition Assessment Process.” This standard provides only a baseline for evaluation, and in most cases is unlikely to provide the level of detail and analysis required to ensure adequate investor protection.

Furthermore, the standard suggests that buyers of these services consider “their risk tolerance level before selecting the consultant and the level of due diligence to be exercised by the consultant.”

Therefore, what the commercial real estate industry is faced with is not necessarily a standard that is inadequate, but rather a standard that is incorrectly interpreted as a comprehensive guide.

Stay informed

Commercial real estate investors should recognize that the ASTM International standards are the minimum requirement, and in the majority of cases will not provide them with adequate due diligence. To ensure adequate protection, investors should ensure that due diligence evaluations completed are all-encompassing in nature.

Evaluations should include assessments of all physical components, a detailed evaluation of the physical condition, code compliance and compliance with intended design, and clear and accurate repair and replacement recommendations, as well as opinions of costs.

Become an informed buyer or seller. Consider attending educational classes or developing an in-house, property-specific due diligence scope requirement.

Ultimately, it all comes down to this: If you are willing to hedge a small initial due-diligence investment against the potentially large financial liabilities of an unknown asset — then be ready. You may just get what you pay for.

Benjamin Dutton is head of the facility assessment group of Faithful + Gould in Alexandria, Va. He can be contacted at benjamin.dutton@fgould.com

DUE DILIGENCE TIPS FOR BUILDING OWNERS

Identify which building systems historically result in the largest capital expenditures.

Spend little effort on building items that are considered to be routine maintenance.

Allow the due diligence providers to propose the scope of the work they believe is necessary to meet your objectives as an owner.